Using equity to pay debt can be risky

Dear Debt Adviser,
We're considering refinancing our mortgage and adding $10,000 to pay off credit card debt. We have 14 years left on a 20-year, 7 percent fixed-rate mortgage with a balance of $112,000.

Our credit union is offering a 15-year, 5.5 percent fixed-rate "refi." Does it make sense to incur the closing costs to make the switch?
-- Roger

Dear Roger,
This is one of those questions where "depends" will appear often in the answer. Due to the mortgage crisis and housing situation in our country right now, I hesitate to recommend using home equity for anything. Your equity may disappear as a result of conditions beyond your control in your real estate market.

However, under the right circumstances, it may still make sense to tap your equity. First off, ask yourself whether homes in your neighborhood have stopped appreciating -- or are actually losing value. Determine what your home will be worth after taking away the $10,000 in equity.

Make sure there's enough equity left over to allow you a cushion. Circumstances happen all the time that put people in the position of needing to sell their homes. You don't want to be in a situation where you would be selling at less than your mortgage value.

Next, consider how your monthly payment will be affected. For the refinancing you describe, your approximate monthly payment would be about $1,000, excluding taxes and insurance.

If that is more than your current payment and may potentially cause you financial strain, consider refinancing to a 30-year loan rather than the 15-year loan. That would lower your monthly payment to approximately $700.

By using the 30-year option, you have the flexibility to make a $1,000 payment if you like, or to just pay $700 if the higher payment is a financial hardship. This flexibility prevents you from having to refinance yet again if you start paying $1,000 a month, then find you need to pare back your payments.

Loan terms aside, I don't want you to lose sight of the real costs and risks of extending payments, even at a lower interest rate. The real cost of a loan is cash out the door and risk.

As for cash out the door, the longer you pay, the more you pay, all things being equal. For example, paying a typical minimum on a credit card debt of $10,000 over an eight-year period at an interest rate of 12 percent results in a monthly payment of about $162. A 30-year repayment at a rate of approximately 6 percent would be a monthly payment of $60.

However, the smaller monthly payment of the 30-year option disguises the fact that it would take a total of $21,580 to pay off the debt, as opposed to $15,602 for the eight-year repayment.

Then there's the risk. Turning unsecured debt into secured debt is usually a bad deal from a risk standpoint. You are taking on more risk, perhaps paying more and not getting much in return.

I'd separate the question of the credit card debt from the refinance decision. My favorite method is to refinance for 30 years and pay as though it was 15. At the same time, aggressively pay down the credit card debt while not adding any new charges you can't pay off in a billing cycle to the card balance.

As for the closing costs, I looked in my area and saw a range of a high of $1,100 and a low of $325. That's not much over a 30-year period.

So, depending on your answers to the questions in this column, you should have a good idea of what the real costs are of adding the credit card balance to a mortgage refinance.

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Debt Adviser

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